Passing on the high side: PECO Energy leads the pack with contrarian strategies

Michael T. Burr

Editor

Walk through the front door at the PECO Power Team offices outside Philadelphia, and you might think you`ve stumbled into the wrong place.

Adorning the wall behind the reception desk are two strange paintings: contorted pig faces splattered in black on white canvas. On another wall hangs a gold and black drapery resembling a gigantic bat. Still another displays the brightly polished hood of a race car. Is this an energy marketing company or a modern art gallery?

When you look closer at the car hood, however, you`ll realize you`re in the right place. This hood came off the Power Team NASCAR stock car driven by Geoffrey Bodine. The other pieces are simply a front-office introduction to the Power Team`s unorthodox working environment, designed to encourage creativity and unorthodox thinking.

Clearly, this is not your father`s utility company.

Compared to traditional, conservative utilities, PECO Energy is aggressive and contrarian. For example, PECO was the first U.S. company to begin buying other utilities` unwanted nuclear plants, starting with Three Mile Island Unit 1. Another example, its Exelon Infrastructure Services (EIS) subsidiary, grew from nothing to a nearly $500 million business in two years. EIS is quickly becoming a leading wires and pipes management contractor-not exactly a popular niche for utility investment.

“We need to change the way the world defines utility,” said PECO Energy CFO Michael Egan. “We`ve got to be bolder, more opportunistic, aggressive and competitive.”

PECO has emerged as one of the most ambitious utilities in the United States, and its management has gained the respect and admiration of many industry leaders. This became apparent when EL&P conducted its Utility of the Year award ballot. The panel of finance, legal and engineering professionals was almost unanimous in recognizing PECO`s excellence. Further its recently announced merger with Unicom promises to strengthen PECO`s foundations and broaden its geographic horizons.

To learn what`s driving the company, EL&P visited PECO`s headquarters in early November and interviewed its top executives.

Hidden gem

Steve Fleischman, Merrill Lynch`s first vice president and a leading utility stock analyst, ranks PECO among his so-called “hidden gems.” In July he advised clients, “PE is one of the few stories that combines an attractive restructuring play with long-term growth potential and a strong management team. We believe the company`s nuclear acquisition strategy at AmerGen, retail supply growth at Exelon Energy and telecom ventures are creating significant future value that is not at all being reflected. If anything it is given negative value.”

In the mid-1990s, PECO Energy began what the company calls a “generation-led” strategy. “About five years ago, we realized our core competencies were infrastructure management-power plants and distribution systems-and energy logistics-the ability to transact and deliver power over transmission networks,” said Corbin A. McNeill Jr., PECO Energy`s chairman, CEO and president. “We`ll be in generation first. We`ll follow that up with distribution components, and we`ll test other marketplaces.”

Here again, PECO followed a somewhat contrarian strategy. Many utilities have chosen the less risky path, divesting their generating assets and pursuing more stable businesses in regulated transmission and distribution. “That`s a choice that management boards have to make in today`s environment. We don`t have a big enough customer base here to live on that kind of a strategy, so we naturally migrated to a generation-led strategy, recognizing the risks,” McNeill said.

To better reflect the different risk profile of the company`s new business plan, PECO cut its dividend payout in January 1998. “This sent a signal to the investment community that we would not be a high dividend payout company. Our dividend payout ratio is probably in the 20-30 percent range. Investors know we`re going to be a different investment risk and style from a traditional utility,” McNeill said.

Having made this decision, PECO focused on growth in both regulated and unregulated businesses. “On the generation side, we saw pretty hefty prices being paid for fossil plants,” he said. “We also saw very few people who were risk takers around nuclear. We set out on our own to work that market.”

PECO formed a partnership with British Energy, called AmerGen, that began acquiring nuclear plants in the United States. “That`s part of a broad generation strategy,” McNeill explained. “It is a buyer`s market for nuclear and a seller`s market for fossil.” Eventually, the nuclear market will be “transacted out,” he said, and the company will shift its focus to acquiring fossil-fired generation.

PECO`s generation business is being integrated together with its Power Team subsidiary. A new building is in construction in Kennett Township, Pa., to house both groups. Already one of the most successful energy marketing companies, the Power Team controls 9,000 MW of generation capacity-mostly from power purchase agreements and one tolling agreement. About 25 people work on the Power Team trading floor, hedging the company`s physical assets in nearly every major wholesale market.

PECO also has established unregulated businesses in telecommunications-related industries and retail energy. More recently, its EIS subsidiary was established to offer turnkey outsourcing of distributed network management, design and construction. EIS is targeting electric, gas and telecommunications utilities, as well as community lighting systems.

“We`re bullish on the infrastructure business,” said Greg Cucci, senior vice president with PECO Energy and president of PECO Energy Ventures, which incubates new businesses for the company. “We applied our infrastructure experience to our acquisitions, selecting partners that extend and complement EIS with strengths in telecom and other areas,” he said.

This large, scattered market has no dominant players yet, but EIS has its sights set on becoming just that. EIS acquired five companies this fall-two telecom contractors, a gas pipeline contractor, a commercial electric contractor and an underground utility installer-with a combined work force of more than 4,400 and annual revenues exceeding $300 million. They include two telecommunications contractors with strengths in the Northeast and across the country, a gas pipeline contractor in the Midwest. Several other acquisitions are expected soon.

“Just as when the telecom industry deregulated 10 years ago, there was a lot of outsourcing of newer businesses. We think the same thing will happen in the utility industry, so we`ve acquired companies to take advantage of that,” McNeill said.

EIS is taking an interesting approach to its acquisitions. The five recent acquisitions cost PECO $194.5 million in cash, plus stock in EIS averaging about 25 percent of the purchase price, according to Egan. “The value is that you have a significant amount of your consideration in the form of a stock that you can`t exercise for a period of time, so you still have some skin in the game. You can`t just walk away,” Egan said. “As the owner of this business, if you can make the stock worth $40 or $50 instead of $25, you`ll get rich.”

Another growth prospect for PECO is the telecom market. The company partnered with AT&T to provide PCS wireless services. “That business is doing very well,” Cucci said. “We`re way ahead of plan.”

PECO also acquired Extant, which provides long-haul, high- speed data switches to local phone companies, and partnered with Hyperion to sell dial tone as a competitive local exchange carrier (CLEC). Its main target market is commercial and institutional customers with phone bills of $5,000 a month and up.

“While these ventures are penalizing PECO`s bottom line, hidden value could start coming out as more announcements arise in coming months,” said Merrill Lynch`s Fleischman. “These could include introduction of highly valued cable service and expansion of the regional footprint.”

Marrying Unicom

PECO and Unicom announced merger plans in September 1999. At that time, Fleischman wrote, “Load up the truck. We see substantial financial and strategic benefits here. It`s accretive to everything … to EPS [earnings per share], EPS growth and cash flow. There is further upside to this with revenue synergies which could be substantial, particularly in wholesale marketing.”

The merged company, with revenues exceeding $12 billion, will rank among the top five U.S. utility holding companies. In terms of market capitalization, the merged company would have ranked third in EL&P`s 1998 Top IOUs report, behind TXU and Southern Co. In terms of total revenues, it would rank fifth (not counting Enron). For comparison, Unicom ranked 10th in total revenues in 1998 and eighth in capitalization, and PECO came in 21st in revenues and 17th in market cap.

At first blush, the PECO/Unicom merger seems like a mating of strange bedfellows. PECO is aggressive in unregulated business ventures, while Unicom`s unregulated efforts have been late and limited in scope. So how do the two fit together?

“These two companies are not as different in their roots as you might think. We`re just a little further down the pike,” McNeill said. “We bring the experience we can give them. They come with a much bigger service territory, more revenue, a more vibrant service territory, and a whole new region in which to expand the unregulated business.”

The companies have three parallel and related businesses, he said: power generation and marketing, distribution and unregulated businesses. The merger with Unicom should advance PECO`s generation strategy, adding about 10,000 MW of additional nuclear generation to the combined portfolio. “We`ll have 17 to 18 percent of the total nuclear generation in the country. We`ll have almost 4 percent of the national electricity market, just in nuclear,” McNeill said. “We`re creating a growth engine in generation that will bring returns that we can continue to reinvest back into our businesses.”

The merger is complementary because the two have very little overlap in unregulated business segments or geographic focus. For example, Unicom has no telecommunications business, but the company does operate a significant proprietary communications network. “We intend to bring that along in the context of an overall communications infrastructure,” McNeill said. “We can lend our experience to the total enterprise to make better use of some of their assets than they might have been doing to date, and we bring marketing philosophy.”

A more subtle synergy also enhances the merger`s attractiveness. “The magnitude of the potential in this merger really didn`t strike me until I began to get a sense of employee feelings,” McNeill said. “As we moved into our generation-led strategy and started to acquire nuclear plants, or started a new business like infrastructure services, psychologically we created the stepchild in distribution.”

PECO`s distribution employees began to feel somewhat left out of the company`s strategy. Conversely, Unicom sold off its fossil generation, creating the opposite dilemma. “John Rowe told the nuclear people they`ve got to produce or get closed, and this created a stepchild on the nuclear side. By bringing these two companies together, we are going to inspire all segments of the business. They`ll feel much more balance in terms of what their role is in the structure.”

As to corporate culture, McNeill said he sees a nice match here as well. “The cultures are different, but only in time, not the end-result.” He explained that both companies have undergone similar crises and transformations-PECO`s involving the shutdown of the Peach Bottom nuclear plant in 1987 and retail choice legislation in the mid-1990s, and Unicom`s concerning trouble with several of its nuclear plants in 1997, its distribution system this year, and competitive restructuring legislation in late 1997. These events brought about management changes at both companies, with a shift in focus toward competitive markets. The key difference is the time scale: “They`re being forced into a much more rapid improvement in some ways than we were,” McNeill said.

Competitive spurs

PECO is well positioned to succeed in the new competitive marketplace, but barriers still exist. Lack of uniform policies from state to state is a key concern, McNeill said. Price differences between regions and service territories give utilities a distinct incentive to remain segmented. Utilities with low power costs, for example, “are reluctant to share that below-market price with higher cost structures that exist in other areas,” he said. “In the Mid Atlantic, we drive prices up in the summer by exporting to the Midwest where you can get higher prices. That creates a reduction in supply here that tends to equalize the marketplace between the two regions.”

Additionally, transmission bottlenecks and regulatory battles involving a variety of issues will hold up the industry`s transition to a fully open marketplace, he said. Conflicts will occur as long as the country lacks uniform policies.

McNeill added, however, that consumer choice will force progress forward. “Consumer choice is a very attractive feature for customers,” he said. “When enough states adopt customer choice, the system will be unstable if the federal government doesn`t act before then. It will be forced to act at some point because of internal tensions that are created in the marketplace.”

This transition is certain to be painful for many utilities. But if PECO`s experience is borne out, they`ll be better off for it in the end. “PECO Energy benefited by moving to a deregulated environment,” Egan said. “It helped drive our culture from an entitlement to a performance ethic, and to execute it in every unit and group of the company. Specifically, we defined the key performance indications that affect rewards. That is now permeated through the business.”

This performance ethic is the engine pushing PECO Energy to the head of the pack in the great competitive energy race. If PECO continues at its current pace, the company seems likely to have a podium finish.

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PECO Nuclear operates the two-unit Limerick generation station northwest of Philadelphia. The plant generates 2,320 MW of capacity. PECO completed a 39-day refueling outage at the plant`s Unit 2 earlier this year, when it also replaced the main turbine.

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The No. 60 Power Team Chevrolet Monte Carlo debuted in the NASCAR Winston Cup series at the Daytona 500 in February 1999. The car is driven by 1987 IROC Champion Geoffrey Bodine. The Power Team also sponsors the A.J. Foyt team entry in the Indy Car series.

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The Eddystone power station (above) is a four-unit facility burning coal, fuel oil and natural gas. Units 1 and 2 burn coal to generate 600 MW, while 3 and 4 burn fuel oil and gas to generate about 800 MW. Nearly 30 percent of PECO`s generation is coal-fired, and another 27 percent is fueled by oil and gas. The two-unit Peach Bottom (below) atomic power station, located on the Pennsylvania/Maryland border, generates 2,320 MW of capacity. The Nuclear Regulatory Commission recently praised PECO for its “strong oversight of plant activities” that improved the plant`s performance.

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Visitors to the PECO Power Team headquarters are greeted by these works of modern art. The building is filled with similar pieces, which are intended to inspire creativity and original thinking among personnel.

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The 512 MW Conowingo pumped storage plant is a strategic benefit for PECO in wholesale markets, storing low-cost, baseload power for use during peak periods. About 28 percent of PECO`s generation is hydropower, including run-of-river and pumped storage.

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“PECO management pushes decisions down to the lowest levels, gives everyone the information they need, offers supervisory training, and expects accountability. Our infrastructure business is the poster child for empowerment.”

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